QUARTERLY LETTER

Published First Quarter 1994
Muhlenkamp Memorandum 29

Three months ago we wrote, "The time to be heavily invested in long bonds has just come to an end" and "Frankly, the most likely trigger for a correction in stocks in the current environment would be an 'uptick' in interest rates, and therefore, a decline in the price of bonds." Short-term hindsight indicates that selling our long bonds at the time I wrote the above would have been a good move because the prices of long-term bonds have since declined 6%. The price of the Dow Jones' Utilities average has since declined 12%. Many of our interest-rate sensitive stocks have corrected as well. The trigger for much of this decline has been the increasing evidence that the economic expansion, which has been at a slow pace for three years, is now picking up a little more speed.

Despite the evidence of the past 30 years, some people still believe that a stronger economy necessarily means higher inflation, and therefore, higher interest rates. These fears are abetted by a brokerage community with an incentive to encourage short-term trading and by a news media with a short-term focus. Both tend to extrapolate short-term wiggles into possible long-term trends and often make mountains out of molehills.

The evidence of the past 30 years has shown that inflation is a monetary phenomenon. If the Federal Reserve Board creates money at a rate greater than the economy grows, you will have inflation. If the money supply is controlled, inflation is held in check. That is why we monitor the actions of the Fed and the growth in the money supply, relative to GNP, to judge probable inflation. We see nothing that implies an increase (in the next twelve months) over today's level of 3% inflation. So our long-term stature remains positive on the markets for stocks and bonds.

Based on today's inflation of 3%, prices of stocks are fair. During the past year, prices of bonds have also reached fair value. Under these circumstances, we believe the market will continue to be a stock pickers market. But we also believe that a price move of 10%, up or down, is possible at any time. Such a move can occur based purely on short-term swings in the emotions of the public. Many people are concerned about a 10% correction, and it has become a frequent topic in the media.

Over the past two years market corrections have been piecemeal, (one sector or industry at a time). So far these sector corrections have been offset by other sector gains so that the major averages have not corrected even though most individual stocks have. We don't know if the market will continue its "rolling" correction; or if it will suffer a 10% correction in the averages, nor do we care very much. Instead we will focus on the individual companies we own, their sales and earnings, and the prices of their individual securities.

Read our quarterly newsletter, Muhlenkamp Memorandum, for more by Ron Muhlenkamp.